In a September 2016 survey, 42% of respondents said CRE lending was their primary focus for loan portfolio growth. More recently, of financial institutions that attended a recent CRE-focused webinar, respondents overwhelmingly acknowledged a CRE focus: 48% said their institutions are still working to expand the CRE portfolio while another 47% said they are continuing to offer CRE loans but are doing so more conservatively. Only 2% of webinar poll respondents said their institution is trying to contract its CRE portfolio.

Credit unions planning additional increases in the CRE portfolio must balance growth with risk management throughout the life of the loan. How do they do this?

Balancing Begins With Origination

Best practices during origination are an important starting point to balance MBL growth and risk. The first step is to define and uphold a process to manage all parties with interests in a deal (member/developer, attorneys, guarantor, equity contributors, appraisers, insurance companies, and local planning and code authorities) and to manage all of the required documents (such as copies of leases and rent rolls, general contractor financials, three years of operating statements, title insurance policies and others). This process should be part of the institution's credit policy and should include specifics for commercial real estate concentrations, and for different property and loan types.

Standardizing processes for collecting documents from all parties and for updating documents as required for covenants ensures the credit union doesn't deviate unintentionally from standards or permit increasing risk. Digital documents can help speed up the process of collection and underwriting, and they can be easier than paper documents to store and access later.

Of course, reviewing the borrower's cash flow – rather than the property value alone – is critical to understanding their ability to repay the loan. In addition to traditional, standard metrics used to evaluate members, many credit unions are also using "debt yield" to evaluate the member's cash flow. Debt yield is calculated as net operating income divided by first mortgage debt multiplied by 100. Unlike the debt-service coverage metric traditionally used, debt yield focuses on the member's ability to pay off the loan and doesn't allow loan-structure adjustments to mask potential weaknesses.

Reducing turnaround times and improving efficiency in origination can also help credit unions remain competitive while managing CRE risk.

Balancing Through Strategic Moves

In addition to incorporating best practices into the origination phase of lending, credit unions can adopt a number of strategic moves to remain competitive and balance risk as they expand the commercial real estate portfolio. Specialization (by property type, geography, size of debt, etc.) is one strategy that allows the institution to maximize its strengths and opportunities. Some credit unions may focus on medical offices, restaurant franchises or summer camps. Others may offer a unique loan structure or make a concerted effort to target members who weathered the recession and have consistently made payments but are now ready to refinance.

An effective pricing methodology accounts not only for costs but also for risks, and setting the institution's pricing policy is part of defining the institution's lending strategy. For example, loans with higher loan-to-value ratios or lower debt-service coverage ratios should be priced higher to account for the charge-offs more likely to be incurred. Consider a probability of default/loss given default matrix to automate the risk portion of pricing. Or consider using the present-value of cash flow to determine pricing.

Balancing Via Portfolio Management

Many credit unions are already stress testing the loan portfolio, and even for credit unions not required by guidance to perform stress testing, the practice can yield benefits that support the credit union's goal of serving members. Portfolio and concentration stress testing is a tool for understanding the credit union's risks, setting limits on CRE lending and other concentrations and for ensuring that the CRE portfolio reflects the institution's risk appetite.

As an example, if a credit union targets loans to restaurants, the institution will likely develop strict underwriting criteria for those loans and track any exceptions to those underwriting criteria. To manage risk to the whole concentration, the credit union may run stress tests to identify the risk to capital if restaurant industry conditions deteriorate.

Robert Ashbaugh is a Senior Risk Management Consultant for Sageworks. He can be reached at 919-851-7474 Ext. 2521 or [email protected].